Short-term money market instruments have a fixed return to maturity. Exceptions may be deposits with unsound banks or bills of doubtful quality, for which we are not sure whether they will be repaid.
You also have to emphasize one underestimated fact. If today we decide to make a term deposit with a solid bank for one year, it means a risk-free investment, its nominal return is perfectly predictable in the one-year horizon. Another situation occurs if we want to make, for example, two consecutive plrons of investments. Although the overall investment horizon does not change, reinvestment risk comes into play: it does not know how many years the rates will pay for the full year.
This fact poses a certain problem for money market fund return estimates. These funds usually invest in instruments with an average maturity of less than ninety days. In addition, they have to deal with continuous drains and drains of the chapter. It is therefore not possible to determine exactly how the returns of these funds will be in a year – this is where reinvestment risk comes into play. With the growing time horizon, the risk understandably increases: we may have some ideas about what the rates for the year will look like, but we can only very little predict the years of peace for three, five or more years ahead.
Example: decline in annual rates and reinvestine risk
For term deposits (if they are held with solid banks) we do not risk losing pensions. The risk of spending the possibility that our inputs will be lower in time, we did not expect.
By the time of the 1980s, American rates were quite high. Ron term deposits deposits ten or more percent and many depositors even in the belief that it will be forever. Whoever would have expected such high rates of kerosene would be very wrong. The Federal Reserve’s anti-inflation policy has led to a rapid and sharp decline in inflation. With a certain bottom, the years of peace have fallen. Stdalov, who “sipped” on 10% of the inputs, later had to settle for many of their rates.
The professional manager of the portfolio will sometimes make similar mistakes as small stocks. At the turn of the 21st century, a problem arose in the entire sector of life associations in Japan. Life insurance companies here (similarly as elsewhere in the world) guarantee clients a certain minimum rate of appreciation of selected insurance premiums. The established amount is then paid to the client at the end of the contractual age. In Japan, insurance companies were required to guarantee a 6% return. This round was not difficult to meet until then, when Japanese rates in the 1990s approached zero. Once highly profitable insurance companies got into huge trouble that go far from being solved. Let us add that the European problem is similar.
Note from 2008: decline in annual rates
The global decline in interest rates since the 1980s is a practical illustration of reinvestment risk. In the first issue of 1999, I considered the money market tool with inputs of around 4-5%. Now, in 2008, it is only possible with a range of input 2.0 and about 3.5%. This is due to inflation, which at the end of 2008 exceeded 7.5%. Reinvest’s risk manifested itself.
ryvek is from the book
“Investin strategy for tet tiscilet“,
vydan nakladatelstvm City Publishing.
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